Chinese economic reform, full front and centre

China’s vice president, Xi Jinping, is set to make a hugely important visit to the US next week, prior to succeeding President Hu Jintao as China’s next president later this year.

The visit will set the stage for interaction between the next generation of Chinese leaders and American political leadership and help to shape how the most important bilateral relationship in the world will be managed over the medium-term future.

In recent times, the political-security dimension of the Sino-American relationship has received increasing attention, as the US ‘pivots’ toward Asia. But core and immediate challenges concern the economic relationship and how rapid change in the Chinese economy plays into US and global interests. These matters will be at the forefront of Mr Xi’s meetings when he visits Washington.

In a recent interview in the Wall Street Journal Nick Lardy argues that ‘if China does not accelerate the pace of reforms that support rebalancing, when global growth resumes a more normal pace, China’s external surplus likely would expand again. That would mean that China again would be subtracting from economic growth in the rest of the world, including the United States. That would make it more difficult for the United States to reduce its budget deficit to put its government debt on a more sustainable path’.

Among the problems, Lardy says, are: a low share of private consumption expenditure and a super-elevated share of investment in GDP; an outsized manufacturing sector and a diminutive service sector; an unprecedentedly large hoard of official holdings of foreign exchange; and an increasingly high and probably unsustainable rate of investment in residential property. Mitigating these imbalances will require fundamental market-oriented reforms. The pace of reform will need to be accelerated to achieve sustainable, domestically driven growth and harmonious relationships in the international economy, notably with the United States.

Chinese economists, such as Yiping Huang at Peking University, have made the same point about the distortions in Chinese markets that need to be addressed to correct imbalances in the economy.

Lardy worries about the tardy pace of reform in China. ‘Market-oriented interest rate liberalisation, eliminating the under-pricing of energy and other factor inputs used predominantly in manufacturing, greater flexibility of the exchange rate and an even more rapid expansion of the social safety net are essential to moving China onto a consumption-driven growth path. Many of these reforms have been on the agenda for a decade or more’, he says, ‘yet with the exception of increased social expenditures, progress has been painfully slow’.

According to Lardy, the explanation is that financial repression, the undervaluation of the currency, and factor price distortions advantage some sectors and regions of China at the expense of others. The benefits of unbalanced growth flow to export- and import-competing industries (which enjoy elevated profits at the expense of firms in the service sector), coastal provinces (which have enjoyed supercharged economic growth at the expense of inland regions), the real estate and construction industries (which have benefitted from interest rate policies that have made residential property a preferred asset class), and China’s banks (which enjoy lofty profits that come with the high spread between deposit and lending rates set by the central bank) who have acquired disproportionate influence over economic policy. And to date they have been able to block much-needed policy reforms. These reforms are necessary if China is to move toward a more balanced, sustainable growth path.

Lardy also argues that there are immediate dangers to strong growth in China from excessive investment in housing and real estate. The share of residential investment in GDP has doubled to more than 10 per cent between 2003 and 2010, a share far higher than that in countries with comparable per capita incomes. This was induced, Lardy argues, in part by households channelling their savings into housing in the face of negative real deposit rates in the state-owned banking system.

While Huang sees less immediate risk of collapse in the housing market, residential housing has become the single most important driver of China’s economic growth since the middle of the last decade. Lardy is right in observing that this cannot last indefinitely, although how long it lasts is a very important question.